Thursday, November 16, 2006

Banks begin reporting fourth quarter earnings November 28th. We are looking for continued earnings resilience with growth expected at 14%. We are upgrading our bank share price targets, reflecting low level of interest rates, dividend and earnings growth and profitability. Seasonality and the flow of funds as a result of the Income Trust tax changes are assisting bank share price performance. RY is our 1-Sector Outperform recommendation. Maintain Overweight Recommendation

Banks Begin Reporting November 28

• Banks begin reporting fourth quarter earnings with Bank of Montreal (BMO) on November 28, followed by National Bank (NA) and Royal Bank (RY) November 30, Canadian Imperial Bank (CM) and Canadian Western (CWB) December 7, Toronto-Dominion Bank (TD) and Bank of Nova Scotia (BNS) December 8 and Laurentian Bank (LB) closing out reporting December 12. Scotia Capital's earnings estimates are highlighted in Exhibit 2, Consensus Earnings Estimates/Target Prices Exhibit 6, Conference call information Exhibit 7, and Dividend Increases and Trends Exhibit 8.

Q4 Earnings Growth Forecast 14%

• We expect fourth quarter earnings for the bank group to increase 14% year over year and 1% sequentially. Earnings growth is expected to be driven by wealth management with solid earnings from retail and wholesale. RY is expected to lead in earnings growth at 17% each, respectively. RY earnings growth is expected to be driven by the strength of retail and wealth management platforms.

• Bank group profitability is expected to continue to run at historical highs on very large capital positions with return on equity of 20.8%.

• Wealth management earnings are expected to continue to be strong, although only three banks disclose these earnings on a separate basis. Bank average mutual fund assets are up 14% from a year earlier and 2.3% sequentially. The banks continue to dominate mutual fund sales; particularly RY and TD with market share of long-term asset net sales an astonishing 40% and 37% respectively during the quarter.

• Retail banking earnings are expected to remain solid, although we expect some slowing in earnings growth in 2007 and 2008 as loan growth slows due to the weakening real estate markets. The major question is to what degree net interest margin expansion may offset the lower volume growth. The prime rate has increased 175 basis points or 41% in the past two years. The increase in prime rate has stalled margin compression as the retail net interest margin has been stabilizing over the past year, reaccelerating retail bank earnings growth. Last quarter the retail net interest margin actually increased modestly.

• This quarter, Q4/06, prime rate was unchanged, the first quarter in over a year (Q3/05) where the prime rate did not increase, which we believe bodes well for further retail margin improvement. This could be a source of positive earnings surprise this quarter. The rapid rise in prime has made margin expansion difficult. However, a stable prime rate going forward may allow the benefits of margin compression reversal to flow through to the net interest margin and may be a source of further bank earnings resilience in 2007 and 2008.

• Wholesale banking earnings are expected to remain solid with the revenue picture mixed, supported by cost containment. On the revenue side, underwriting is expected to be weaker, partially offset by continued strong M&A revenue with equity trading volume up. TSX IPO's $ value declined 59% in Q4 sequentially with the number of deals down 7%. Canadian M&A Deals closed by Value increased 43% sequentially. Equity markets were relatively strong in the quarter, with S&P/TSX increasing 4.3%, TSX trading volume up 7% and trading value up 5%. In terms of fixed income, bond yields in both Canada and US declined by 29 bps and 38 bps, respectively, during the quarter. The wholesale net interest spread was positive in the quarter, improving 4 bps with prime - BA spread averaging 167 bps. Loan loss provisions are expected to remain extremely low.

• Other earnings factors in the quarter are that stock based compensation is expected to be up due to the 9% increase in bank share prices during the quarter. The C$ weakened slightly in the quarter against the US$ and 2.6% against the Peso.

Dividend Increase Candidates BMO, CM and NA

• Dividend increase candidates this quarter are BMO, CM and NA, with dividend increases expected to be in the 4% to 8% range (Exhibit 8). This follows dividend increases announced in the previous quarter by RY and TD of 11% and 9%, respectively.

• The bank group's dividend payout ratio on our 2006 earnings estimates is 44% and 40% on our 2007 earnings estimates, with BMO at a high of 49% and NA and TD the low at 40% and 41% respectively. We continue to expect bank dividend payout ratios to drift towards 50%.

Stock Split Candidates CM, BMO, TD and NA

• CM, BMO, TD and NA are stock split candidates given their respective share price levels, with CM the most likely. This follows stock splits by RY and BNS in March 2006 and March 2004. Fiscal 2006 Earnings Growth Forecast 14.6% - Fourth Straight Year of Growth Averaging 17%

• Banks are expected to wrap up another very strong year in 2006 with earnings growth of nearly 15%, the fourth year of high growth. Bank earnings growth was 22%, 16%, and 16% in 2003, 2004 and 2005 respectively. Profitability is expected to be a record with return on equity of 21.4%. The leader in earnings growth in 2006 is expected to be RY for the second straight year at 19% with NA and BMO growth lagging at 9% and 12% respectively.

Upgrading Bank Share Price Targets

• We are upgrading our bank share price targets 7% based on a target P/E multiple of 16.1x on our 2007 earnings estimate versus our previous P/E multiple target of 15.1x. The increase in our target multiple is consistent with our long term forecast multiple supported by the continued low level of interest rates. Our long term 16x P/E multiple target is based on a 5% government bond yield, not the current 4% and is based on bank fundamentals including level of profitability, balance sheet strength, revenue mix, low earnings volatility and solid long term earnings growth rates.

• In addition to banks having compelling valuations on a yield basis versus bond yields, pipes & utilities, income trusts and overall equity markets, banks should benefit from flow of funds. We expect the difficulties in the income trust market to create increased investor demand for bank stocks. In addition, enhancements to the dividend tax credit should be beneficial to bank share prices as the tax benefits work through the system over the next few years. Banks should also benefit if there is sector rotation away from the resource sector to more defensive stocks. The banks' one year beta is at historic low levels at 0.39.

• Bank stocks are outperforming the TSX year-to-date with the bank index up 14% versus 10% for the overall market. The bank index is also outperforming the market thus far in the fourth calendar quarter, up 6.4% versus the market at 5.6%. If this outperformance holds, this will represent outperformance in 23 out of 27 years in calendar fourth quarter.

• Banks are trading at a low 13.3x our 2007 earnings estimates, with bank dividend yields relative to bonds (Exhibit 13), equity markets (Exhibit 14), income trusts (Exhibit 16), and pipelines and utilities (Exhibit 15) all in the Strong Buy range. Reversion to the mean would result in the bank index increasing on a relative basis by 44%, 31%, 14% and 27% versus the bonds, equity markets, income trusts and pipes & utilities.

• Canadian Banks' are trading at a 9% premium to the major U.S. banks and 13% discount to U.S. Regional Banks. The Canadian Banks premium, we believe, is fully supported by the respective government bond yields and lower earnings risk in the Canadian Banks, higher profitability and stronger capital positions.

• We continue to have no sells in the bank group on an absolute return basis.

Fourth Quarter Highlights

• Bank of Montreal is expected to report $1.29 per share, a modest 5% YOY increase and a decline of 1% sequentially. Security gains have a low level of sustainability ($0.02 per share in the previous quarter) given minimal unrealized security surplus. We expect the bank might be challenged to repeat the level of trading revenue that it recorded in the previous quarter. A dividend increase of 6.5% to $2.64 per share is expected.

• Canadian Imperial Bank is expected to report $1.65 per share, an increase of 14% YOY and a decline of 3% sequentially. CIBC has been very successful at cost reduction, with revenue and market share weakness its biggest challenge. A dividend increase of 4.3% to $2.92 per share is expected.

• National Bank is expected to report $1.23 per share in the fourth quarter, an increase of 12% YOY. Wealth management earnings should remain solid; however the bank has been very reliant on security gains over the last few quarters for earnings growth. A dividend increase of 8.0% to $2.16 is expected.

• Royal Bank is expected to report $0.95 per share, an increase of 17% YOY and 4% QOQ. Retail and wealth management earnings are expected to remain solid with overall earnings quality high.

• Toronto-Dominion Bank is expected to report $1.22 per share, an increase of 15% YOY. Retail earnings are expected to continue to be the earnings driver, with the U.S. platforms a drag on earnings growth. TD Ameritrade earnings contributions for Q4 are estimated at $0.07 per share versus $0.08 per share in the previous quarter with TD Banknorth earnings of $0.09 per share, unchanged from the previous quarter.

Recent Events

BMO – Acquisition of First National Bank & Trust

• On September 27, BMO announced that its U.S. subsidiary, Harris Financial Corp., agreed to acquire First National Bank & Trust (FNBT) for US$290 million. The transaction is expected to close in January 2007. Excluding one-time items, the transaction is expected to be accretive to BMO's cash EPS in year one. FNBT has 32 branches and 33 ABMs in Indianapolis and the surrounding communities of Kokomo and Terre Haute.

RY – Further Extending Global Exposure

• On September 6, RY announced its intention to acquire American Guaranty & Trust (AG&T) of the National Life Group. The acquisition allows RBC to provide U.S. trust solutions to high net worth clients. AG&T has over 30 employees and holds more than US$1.3 billion in trust and investment accounts. The transaction closed on October 3, 2006.

• On September 19, Goldman Sachs JBWere Asset Management announced that it had selected RBC Dexia Investor Services to provide fund administration and transfer agency services for its AUD$8 billion portfolio of funds in Australia.

• On October 17, it was announced that RY is among four banks to lead a multi-billion pounds infrastructure loan backing Australian investment bank Macquarie's 8.0 billion pounds bid for Thames Water. Other banks include Barclay's Bank, Dresdner Kleinwort and HSBC.

• On October 25, RBC Capital Markets entered into an agreement to acquire the broker-dealer business and certain of assets of Carlin Financial Group (CFG). The transaction is expected to close in the first quarter of 2007. Terms of the transaction were not disclosed.

• On October 30, RY entered into a joint venture with China Minsheng Banking Corp. to launch a new Chinese joint venture fund management company. The joint venture will create, manage and sell mutual funds in local currency to retail and institutional investors in China. Under the agreement, RY will hold a 30% interest, China Minsheng Bank will hold 60% interest and Three Gorges Finance Co. will hold the remaining 10% interest.

• On November 1, RBC Centura Bank agreed to acquire 39 branches in Alabama from AmSouth Bancorporation (ASO.N). This transaction will make RBC Centura the state's 7th largest financial institution by deposits. As at July 31, 2006, ASO had US$1.5 billion in loans and US$2.0 billion in deposits. Terms of the transaction were not disclosed and expected closing is March 2007. This transaction is not expected to have a material impact on RY earnings.

TD – TD Ameritrade and TD Banknorth Earnings Weak

• TD Ameritrade (AMTD) reported Q4/06 cash earnings of US$0.21 per share, versus IBES estimate of US$0.23 per share. At its current ownership level of 39.5%, the contribution to TD would be C$53 million or C$0.07 per share.

• TD Banknorth (BNK) reported Q3/06 cash earnings of US$0.51 per share, versus US$0.56 per share in the previous quarter and US$0.63 per share a year earlier. Consensus was US$0.52 per share for the quarter. TD Bank (TD) indicated that BNK's contribution this quarter would be C$63 million or C$0.09 per share versus C$0.09 per share last quarter and C$0.10 per share a year earlier.

• On September 28, AMTD announced the realignment of its management team, effective September 30. Bill Gerber took on the role of Chief Financial Officer, with Randy MacDonald the new Chief Operating Officer, Chris Armstrong the new Chief Strategy Officer and Asiff Hirji the new President of the Client Group.

• On October 23, BNK announced that Bharat Masrani will assume the role of Chief Executive Officer effective March 1, 2007 in addition to his current role of President to which he was appointed on June 23, 2006.

• Between October 26 and October 30, TD purchased 233,000 shares of BNK at an average cost of US$29.86 per share, bringing its total ownership level of BNK to 130.1 million shares or 57.0%.